Warren Buffett prefers businesses with a natural franchise
You can buy a legal franchise like McDonalds or you can have a business with a natural franchise. Like a local newspaper or maybe the “best” steakhouse in town.
A good natural franchise has a particular advantage. People who want to use the generic service, like print advertising, must pay the appropriate price. Economists call it “rent.” The ability to extract the rent is a serious business advantage.
Some are quite obvious. Dairy Queen. Duracell, See’s Candies, Burlington Northern Sante Fe railroad, and Pampered Chef. Not to mention Geico.
What is the natural franchise advantage?
It is three-fold.
- They have a pricing power. The ability to charge what they need or want. Increasing margin without a material fall off in volume. I doubt you will ever see a Barkshire company compete on the basis of price. Pricing power lets you increase margin without altering overhead.
- They understand what customers want or need and are willing to pay for.
- They are very hard to compete with because they have enough market share and there are other barriers to starting up. The principle barrier is the businesses have relatively high fixed costs and high margins. Operational leverage. If you don’t break even until you hit 80% of capacity, you don’t start when there is an entrenched competitor.
How do you keep the natural franchise advantage?
Again it is multi-dimensional
- Disciplined management. Do not tinker with things that work. It is okay to try to improve, but it is not okay to change just for the sake of change. Buffett is a classic leave the management alone sort of guy. He is, however, intolerant of management that harms the brand.
- Price discipline. Competing on price is a race to the bottom. Never begin. It is hard to stop later.
- Cost leadership. Work at reducing costs without reducing service or quality.
- Capital Leadership. In highly competitive markets, the business with the most money always wins.
The result is growing free cash flow.
Ultimately that’s what drives business value. You can assess your own business in the same way.
Buffett and Munger work at widening the moat. Do what makes your business harder to compete with. They talk about making it wider and deeper and if that is not enough, put some alligators in it. More cash flow.
More free cash flow allows reinvestment in the business. Open another store, buy a competitor, buy a machine that is more efficient than the one you have, pay down expensive debt, do research. Free cash flow is the one metric that establishes clear value. Income is a shadow of it and managing income is not a guarantee of success.
Think through the general case.
Suppose you made a million dollars pretax. You give the government $250,000 of it for taxes and spend another $1.5 million to stay competitive in your industry. Free cash flow is negative. Did you really make a profit?
Amazon has no income but enormous free cash flow.
Think about your business purpose. Income and cash are not the same thing. Notice how to manage the distinction when organizing your retirement plan
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.
In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772